Unique sector ETFs give equal weight to stocks in benchmark index

JohnSpence

The Rockville, Md.-based investment manager, looking to build on the success of a unique ETF that distributes assets evenly among the stocks in the Standard & Poor's 500 Index
SPX, +0.59%
last week introduced sector-based funds with a similar strategy.

Most of the indexes to which ETFs are benchmarked rank individual companies according to market capitalization, but alternative schemes, such as weighting companies equally or by their fundamentals, are becoming popular. Backers say market-cap weighting gives too much focus to larger companies.

For example, the S&P 500-tracking SPDR Trust
SPY, +0.60%
a market cap-weighted ETF, had a 3.5% position in energy giant Exxon Mobil Corp.
XOM, +0.77%
its largest holding, as of Nov. 8, according to portfolio manager State Street Global Advisors. Additionally, about 20% of assets were in the top 10 holdings, including market bellwethers General Electric Co.
GE, +0.79%
Microsoft Corp.
MSFT, +1.57%
and Citigroup Inc.
C, -0.18%

Meanwhile, Rydex S&P Equal Weight ETF
RSP, +0.28%
which has amassed a respectable $1.8 billion of assets since its 2003 launch, aims to invest 0.2% in each of the 500 stocks in the index. The equal weighting isn't exact because stock prices are constantly shifting, but Rydex rebalances the ETF on a quarterly basis to get back to the target.

"The idea of equal weighting is better access to all the stocks in a sector," said Tim Meyer, ETF business manager at Rydex.

"If there's strength across a sector, equal weighting tends to outperform, but market-cap weighting can do better depending on the market's leadership," he added.

Rydex's equal-weighted S&P 500 ETF has benefited from its tilt to the smaller companies in the index in recent years. Through Nov. 9, the fund has a three-year annualized return of 14.3%, outpacing the market-cap weighted S&P 500 by nearly 3 percentage points, according to investment researcher Morningstar Inc.

Yet the trend may be due for a reversal. Many fund managers see large-cap stocks assuming market leadership after trailing smaller companies for several years. See related story.

An ETF investing in U.S. small-cap stocks, iShares Russell 2000
IWM, +0.20%
was up 14.5% this year as of Nov. 9, edging out the 12.4% return for the large-cap SPDR Trust, according to Morningstar.

Reducing single-stock risk

Jim Lowell, editor of MarketWatch's ETF Trader newsletter, said investors could find the new equal-weighted sector funds a useful option to reduce the risk of a blow-up in an industry leader. "The principle of diversification works," he said.

Still, he noted that over the long term, there shouldn't be a dramatic difference in the performance of equal- or market-cap weighting.

"There's a big intellectual argument going on over the approaches, but it really comes down to marketing, not the market," Lowell said.

The rival strategies, however, should create different-looking portfolios, especially in sectors dominated by a few large companies.

The Energy Select Sector SDPR
XLE, +0.31%
for instance, has more than 36% concentrated in just two stocks: Exxon Mobil and Chevron Corp.
CVX, +0.56%

On the other hand, the new Rydex S&P Equal Weight Energy ETF
RYE, +0.11%
attempts to equal-weight its 29 holdings with each stock at roughly 3.4%.

The equal-weighted approach "prevents single-stock risk and avoids the concentration issues" that often impacts sector ETFs, said Dodd Kittsley, director of ETF research at State Street, in a previous interview.

Equal-weighted indexes have enjoyed a tailwind the past few years, said Srikant Dash, index strategist at S&P.

"They've done better coming out of the bear market due to the relative outperformance of smaller stocks," he noted. "There was demand for equal-weighted sector indexes which would add up to the S&P 500."

Some of the S&P equal-weighted sector indexes have outperformed their market-cap counterparts in recent years by a wide margin. Using data from S&P, Rydex says the equal-weighted version of the consumer discretionary index, for example, posted an annualized return of 13% for the five years ended Sept. 30, compared to 7.3% for its market-cap weighted sibling.

The new equal-weighted sector ETFs from Rydex have annual fees of 0.5% of assets, although that doesn't include trading commissions because ETFs are bought and sold like stocks.

Rydex's equal-weighted sector ETFs aren't the first of their kind. State Street offers several comparable ETFs that track narrow sub-sectors, including SPDR Homebuilders
XHB, -0.39%
and SPDR Metals & Mining
XME, -1.87%
The tracking indexes area also managed by S&P.

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